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Illustration by Krieg Barrie

Year-end planning is finally here

Personal Finance | But what a year it's been for most Americans' finances

Issue: "'To stay is to be killed'," Nov. 29, 2008

The year 2008 has been one of the most difficult years economically that many have ever lived through. The stock market is on track for its worst performance in over 30 years; home values have declined; unemployment sits at 6.5 percent-its highest level in nearly two decades-and is rising. For many households, "recession" is not just an academic term.

Economic downturns are part of the business cycle. This particular downturn, and the role that a collapse in global credit markets played in causing it, is unique in many ways. But it certainly is not unique in this sense: We have seen bad times before, and we will see bad times again. But year-end tax planning can help to mitigate some of the pain of this year's economic difficulty.

It is a sad fact in the U.S. tax code that when an investor "realizes" a gain of $50,000 on an investment, he pays capital gain taxes on all $50,000, but when an investor "realizes" a loss of $50,000 on an investment, he only receives a tax deduction of $3,000. The 1977 level has never been adjusted for inflation and stays constant regardless of the level of "realized" loss. The term realized means nothing more than selling an investment, thereby creating either a gain or a loss. Merely owning an investment at a gain or a loss (without selling it) is not (yet) a taxable event.

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In a year like this year, where many investors have losses in their portfolio, "realizing" some losses may be the best thing to do. While you cannot gain more than a $3,000 income tax deduction, you can do two other things that are very important: (1) You can use other losses above and beyond $3,000 to offset other gains you may have this year; and (2) you can "carry forward" the losses above and beyond $3,000 to future years.

It may hurt now, but few would argue that a day and age of investment gains will never return. At some point, markets will normalize and investors will experience capital gains again. In fact, in this political climate, future realized capital gains are likely to be taxed at a higher rate than they are now. By realizing losses now, and harboring a "tax loss carry forward," you are adding to the net present value of future investment gains.

The difficult part is this: The tax code calls for something called a "wash sale rule," where you cannot buy back investments you sell at a loss for 30 days if you are to claim a tax loss on that sale. In those 30 days, the investments you sold to realize a tax loss could experience substantial gains in their value. It is very important not to sell investments for tax purposes without consulting with your tax or investment advisor. One common transaction is to sell a mutual fund at a loss to realize the tax benefit, but then buy another comparable mutual fund the same day.

The worst fear of an investor is to lose money. The second worst fear ought to be losing money without gaining a tax advantage. Consider your situation in light of this year's activity, and consult your advisors to make sure you go about it the right way. You may end up being far better off for it.

In our next column ...

... we will look to other late-year tax planning strategies that may be appropriate for you, primarily centered around retirement accounts (401k contributions to reduce taxable income and maximize employer match and converting traditional IRAs to ROTH IRAs if this year is resulting in a lower-than-normal tax bracket). This is an exhaustive topic, but when an exhausting recession hits, sometimes this kind of tax planning is just what the doctor orders.

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